There is growing concern about interest rate volatility — and with good
reason. A number of factors, including housing concerns, subprime issues and
inflationary pressures, are pointing towards a period of volatility for interest
rates.
Interest rate risk is the monetary exposure companies are faced with due to fluctuations in interest rates. When interest
rates change a company’s floating rate debt
is impacted, which can lead to unexpected
increases in interest expenses.
“Since interest rate volatility is a certainty, companies should be concerned with
managing this risk because of the effect on
future cash flows,” says Chris Ramos, corporate banking officer of Comerica’s
Western Market.
Smart Business spoke with Ramos
about interest rate risk, how it can best be
managed and the benefits that interest rate
swaps provide.
How can a company best manage interest
rate risk?
First, companies need to assess the
impact on cash flow if interest rates were
to rise and their tolerance to this risk. For
example, a large company with significant
cash flow relative to the amount of debt it
has may be able to absorb, to a larger
extent, the impact of rising interest rates.
However, a highly leveraged company is
going to be extremely sensitive to even a
slight increase in interest rates.
Regardless of the level of risk tolerance,
companies should evaluate which financial
tool may be best suited to limit this risk and
not only minimize the impact on cash flow,
but also maximize the predictability of
future interest expense.
What specific kinds of mechanisms are available?
Three commonly used mechanisms,
aside from the traditional fixed rate loans,
are interest rate caps, interest rate collars and interest rate swaps. Interest rate caps
limit the cost of floating rate debt for an
upfront fee while maintaining the benefit
of a drop in interest rates. Interest rate collars combine a cap and a floor on interest
rates for potentially zero cost, depending
on where the maximum and minimum levels are set. Interest rate swaps essentially
provide a fixed rate of interest on floating
rate debt.
What benefit does an interest rate swap provide?
The primary benefit of an interest rate
swap is that there is no cost to establish it,
and it provides a fixed interest rate, eliminating the impact of rising cost of funds
and enabling companies to better forecast
their interest expense. Additionally, interest rate swaps are extremely flexible and
can be structured to match any portion of
the underlying floating rate debt.
How does this differ from a fixed rate loan?
It is, in fact, very similar to a fixed rate
loan except that it is actually a combination of two separate agreements: a floating
rate loan contract and an interest rate
swap contract. As the interest rate on the
floating rate loan fluctuates, the nominal
cost or benefit associated with those fluctuations is offset by the nominal cost or
benefit that results from having the interest
rate swap contract.
Since the floating rate loan is a separate
contract, there is no prepayment penalty
for paying off the loan early. The interest
rate swap contract can then either be used
to hedge other outstanding debt or be cancelled.
What happens if the interest rate swap contract is cancelled?
If interest rates have fallen, then the contract is considered to be ‘out of the money,’
and the cost to unwind the contract is the
market value loss, which is typically significantly less than a prepayment penalty on a
traditional fixed rate loan. If interest rates
have risen, then the contract is considered
to be ‘in the money,’ and the owner of the
contract may actually receive money for
unwinding the interest rate swap. In this
scenario, the borrower is actually paid for
paying off the loan early.
CHRIS RAMOS is corporate banking officer of Comerica’s
Western Market. Reach him at [email protected].
